Discussion hosted by The Realization Group, led by Vela, Aquis Exchange and Hudson River Trading, on May 23, 2018

MiFID II is intended to deliver better outcomes for end-investors across Europe, by increasing transparency, consumer protection and competition, while reducing cost, risk and conflicts of interest. To achieve these aims, the new directive introduces some major reforms to Europe’s equity markets: common transparency and reporting rules; tougher best execution requirements; and a limit on trades that don’t contribute to price discovery. At six months in, it’s too early for investors to feel the benefits. But it’s clear that many market participants are committed to MiFID II’s aims as they start to execute trades via new mechanisms such as systemic internalisers (SIs).

Trading venue operators, liquidity providers and seekers are anticipating the release of the first execution quality data under MiFID II’s RTS 27 at the end of June. This will reveal for the first time the pre- and post-trade data reported by trading venues, including SIs, as required by MiFID II’s new transparency rules with the intention of helping investment firms deliver best execution to end-investors.

The sense of expectation was palpable at the May 23 roundtable hosted by Vela at London’s Saddlers Hall, as was the sense of frustration that the data is being published only after a three-month delay, rather than on a T+1 basis, and is likely to be inaccurate and incomplete, until data reporting and aggregation processes bed in. Indeed, if official data does not deliver the transparency needed to improve end-investors’ outcome, SI operators may take matters into their own hands.

Early indications of interest

Anecdotal evidence suggests that SIs operated by broker-dealers and electronic liquidity providers (ELPs) are both receiving orders via smart order routers from firms seeking liquidity through bilateral market-making channels. However, it is impossible for SI operators to be certain of their market share or the execution quality they are providing without further corroboration.

A number of roundtable participants saw similarities with the early days of the original Markets in Financial Instruments Directive (MiFID I), when brokers and their clients tentatively explored the trading experience available from new venues set up in competition to national exchanges, both dark and lit. Then as now, firms are submitting small orders (brokers initially sending only internal flow), then committing gradually more flow once rigorous scrutiny of TCA data proves satisfactory.

One participant pointed out that the buy-side had been presented with a range of execution options following the elimination of broker crossing networks in MiFID II and its imposition of limits on dark trading volumes below block thresholds. “A number of solutions are emerging – not just SIs but periodic auctions – however none are a direct replacement. SIs are just one way to solve one problem for one set of clients, alongside many other options. But we need the data to determine whether SIs are providing a kind of interaction for a particular need. Further, we should remember that good execution is not about a single point of data, but requires instead a wider conversation,” he said.

Another contributor suggested that greater transparency on execution performance would support wider market participation by investors, but also offered a caveat. “Transparency changes results – this is what MiFID II does. If we get better results for investors we get growth; if we don’t, we won’t,” he observed. “If we can lower costs for end-users that is good for industry. But the market has got to be competitive, fair and equal.” It was also noted that fast growth in SI market share beyond the 8-10% achieved by dark pools pre-MiFID II could weaken public confidence in the European equity market’s price discovery process.

Introducing transparency

Roundtable participants cited a number of teething troubles with the new regime, notably in determining the addressable liquidity available from individual SIs, due to uncertainty over reporting and flagging issues. This makes it hard for brokers to update the routing logic of their smart order routers (SORs) in order to take advantage of new liquidity sources. However, speakers argued that such initial problems could and would be overcome over time, drawing parallels to the use of technology to increase transparency in other spheres.

“Look at sports. When you introduce transparency, it never works the way it should first time, as football is experiencing right now. But given time, the issues can be addressed, as has been seen in tennis and cricket. After a few years, we look back and wonder how we could have lived without it,” observed one participant, adding that ELP SI operators had held informal discussions on providing greater transparency.

Even with improved transparency, MiFID II’s SI regime is a significant change from previous execution mechanisms, requiring brokers to update and rethink their SORs while SI operators learn how to adjust their price feeds to different types of order flow.

“SORs have not really evolved that much in recent years. So today the main conversation we’re having with clients are around data and transparency and stitching together a full picture of liquidity,” noted Ollie Cadman, Head of Business Development at Vela. Other participants agreed that achieving best execution for the end-investor remained a complex challenge under MiFID II, noting that execution performance via SIs rested on multiple factors which needed to be discussed and understood by market participants over time. While SI operators can tailor their price feeds to different types of buy-side order flow, execution quality also depends heavily on the broker’s trading infrastructure and approach to finding liquidity, he noted.

Investor returns

Trading and execution experts around the table agreed that the nature of the change being brought about by MiFID II was still unknowable without more data, but expressed confidence that the first faltering steps toward transparency could bring substantial rewards to investors – and those that serve them.

“MiFID II represents a phenomenal opportunity,” said one observer. “This business will be very different in five to ten years. Regulators don’t care about exchanges or intermediaries, but they do care about the end-investor. If you’re not helping the end-investor, you’ve got the wrong model.”

While accepting the scale of the data challenges facing the industry, Vela’s Cadman noted a contrasting and positive tone to that witnessed ahead of the original MiFID. “Ten years ago, exchanges were hoping MTFs would just go away. Now everyone’s around the table focusing on the end-investor – that’s a positive story that we can take forward into other areas of mutual interest,” he said.